S ince the 2008 financial crisis, expectations for rising interest rates have risen in fits and starts. But every time a rate hike appears imminent, the expectations have been frustrated as a new crisis — from the Arab Spring to the tsunami in Japan to the recurring flare-ups in the European sovereign-debt crisis — leads to more panic buying of dollars and Treasuries, and then to declining interest rates.
In the midst of another post-crisis period of receding risk and rising interest rates, we contemplate whether the era of traditional core fixed-income investing (Treasuries, agencies and mortgage-backed securities) is indeed finally over, and where to be invested instead.
From the interest rate peak in the 1980s to the 2008 credit crisis, core fixed-income investing provided a portfolio with both real income (income in excess of inflation) and principal preservation. Its ability to do both at one time — with the same instruments — resulted from two critical features, one notably missing in today's, and tomorrow's, fixed-income environment.
The first is familiar: a secular decline in interest rates resulting from the success of the Paul Volcker-led Federal Reserve's determination to regain its inflation-fighting credibility after the mistakes of the 1970s.
MISTAKES PAID OFF
The second is less familiar: As a consequence of those 1970s mistakes, fixed-income investors from the 1980s to 2008 benefited from yields well above the level of inflation.
Over the course of those 30 years, traditional core fixed income further helped to preserve principal by going up when all other asset classes went down. This essential “ballast” to an investor's portfolio helped to reduce overall losses in stressful times. Yet the cost for adding portfolio ballast was no cost at all.
Indeed, over this 30-year period, traditional core fixed income offered average annual returns on par with stocks — and with lower volatility. Such performance characteristics resulted from this unique period of secularly declining interest rates and high real yields.
Traditional core fixed-income investing remains an important part of an investor's portfolio. Ballast is still required. When everything else in the portfolio goes down, what makes up the majority of core fixed-income strategies — Treasuries, agencies and mortgage-backed securities — can be the only thing that goes up.
Today, however, the bonds purchased by the Fed for its balance sheet drive up prices and drive down yields until the income they offer stands well below the inflation rate. Such policies reflect policy choices akin to “financial repression” (e.g., explicit or indirect capping of interest rates), making the cost of such ballast greater than at any time in the past 30 years.
In the context of these challenges, and with unprecedented accommodative monetary policies flooding markets, we expect interest rates to rise modestly through year-end to around 2% for 10-year U.S. Treasury notes. Although small, it would mean that rates are finally above the trough. This also serves as a reminder of the risks inherent in investing where duration risk exceeds yields.
In such an environment, investors should reduce the interest rate sensitivity of their portfolios by reducing allocations to traditional core fixed-income investments.
NO LONGER OPTIMAL
The traditional core-fixed-income investing style would concentrate the majority of the fixed-income allocation to interest rate risk instruments (either directly, through Treasuries and other sectors whose performance is tied primarily to interest rates, or indirectly, through owning mutual funds with durations greater than their yields). But this no longer represents the optimal fixed-income investment strategy in today's financial markets.
Today, liquidity in financial markets from global central bank intervention means corporations can refinance debt easily, keeping default risk low.
Increasing allocations to credit risk in sectors such as corporate and high-yield bonds, and floating-rate instruments, can offset yield lost because of a reduction in portfolio interest rate risk.
Allocating away from traditional core fixed-income-style funds with fixed-duration targets toward flexible-style funds with the ability to alter their duration profiles so as to achieve a yield in excess of duration can provide investors with the real income and ballast expected from the fixed-income allocation.
Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.
